Is inflation good for the economy?

IN any Economics 101 course, students often come to understand that a modest level of inflation is good for the economy as a whole. A good level of inflation contributes to increased production, as more money translates into more spending, which directly affects aggregate demand.

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This stems from the ideology of the famous British economist John Maynard Keynes, the father of the Keynesian economic model, who assumes that “the level of investment in the economy must exceed its savings rate in order to promote economic growth” .

Keynes believed that aggregate demand was driving production, not supply. To stimulate aggregate demand in the economy, the government would have to spend and invest heavily.

Even if the government has to go into debt, in the name of economic health, it is the most direct way to achieve its goal.

Keynes’ ideology was shaped by the Great Depression of 1929, where he realized that the only way out of a recession was to increase spending in the economy.

If the economy is in a recession and everyone cuts spending, including the government, it creates a vicious cycle that makes the recession even worse.

Reduced demand will lead to lower production and hence unemployment. Keynes’ “Paradox of Savings” categorically asserts that net savings are bad for the economy. Overall, where does inflation come into play?

To make it less theoretical and fun, let’s talk about the Big Mac Index. The Big Mac Index first appeared in 1986 in The Economist, which measured purchasing power parity (PPP).

Due to McDonald’s massive expansion around the world, Big Mac, the popular beef burger that is a common feature on the menu in most countries, has become a benchmark for measuring PPP and forex value between various countries.

Pam Woodall who created this illustration with a touch of humor gave birth to “Burgernomics” which remains relevant today. For illustration purposes, let’s compare a Big Mac à la carte in Singapore that costs RM 6.40 (RM 19.84) compared to RM 11.60 in Malaysia. The implied PPP is 1.767.

This basically means that Singapore’s purchasing power is stronger than Malaysia’s by this ratio. Moreover, if we measure the current exchange rate of 1 Singapore dollar to 3.1 ringgit, it would imply that the ringgit is 75% undervalued against the Singapore dollar. As of July 21, 2021, Malaysia was ranked 50 out of 56 on the Big Mac Index and against the US dollar, deemed to be undervalued by 58%.

PPP is a measure for comparing economic productivity and living standards between countries. The basis is the “law of one price”. While this works as a useful indicator in theory, economic forces in real life would counteract accuracy, such as different tax regimes and inflationary pressures. There have subsequently been many variations of the original Big Mac index, such as the “Tall Latte” index, which relied on Starbucks franchises around the world for comparison.

The economist used the Consumer Price Index (CPI) which measures a basket of goods to determine the economy’s rate of inflation. Using the price increase of the Big Mac Index year over year would be a convenient comparison to the CPI. Personally, I prefer to use the “Nasi Lemak index” in particular to assess the rate of inflation in the local context. The “Nasi Lemak” is made with eggs, anchovies, cucumber, rice, coconut, chili, oil and chicken. For this reason, it is a good representation of the daily essential basket of goods, besides being our favorite local dish.

For a very long time, the Federal Reserve (Fed) has set itself an annual inflation target of 2%. Policymakers believe that a slow and gradual increase in the aggregate price level maintains corporate profitability and even prevents deflation. Healthy inflation is brought about by healthy economic growth.

It is usually the result of expanding GDP, growing wages, increasing investment activity and consumer spending. It also contributes to full employment levels. The concern is whether the inflation we face today is potentially going to soar, leading to stagflation or even hyperinflation. Due to a common misconception between stagflation and hyperinflation, I have to revisit the 1970s to distinguish it, as many experts and “gurus” have used the word “hyperinflation” loosely.

In the late 1970s, inflation in the United States was skyrocketing to a rate of 13% in 1979, followed by 13% again in 1980. This was attributed to President Nixon who ended the benchmark -gold in 1973. The dollar fell in the foreign exchange markets. . This pushed up import prices, exacerbating “imported inflation”.

The Fed chairman who followed tried to control inflation, but did a bad job simply because consumers and businesses started buying ahead for fear the price would continue to rise. Then Paul Volcker entered the scene. A steadfast and independent-minded Fed chairman, he drastically hiked interest rates from 8.5% in one year to a high of 20%.

He did so independently of the opposition to overcome savage inflation in the growing economy. He managed to bring inflation down to a moderate level, but the side effect was an 18-month recession. Many industries like real estate and the auto industry have been affected, falling victim to high interest rates.

However, by the time he left office, the economy recovered and ushered in 20 years of strong economy for the United States. This inadvertently helped President Ronald Reagan win the election and built a strong presidential legacy throughout his tenure. Thinking back to that time, it was when the United States experienced stagflation and the “Volcker shock”.

So those who propagate “hyperinflation”, IMHO, have not studied enough to understand the real situation. Hyperinflation is usually out of control, with the inflation rate reaching almost 50% per month. This usually only happens in times of war, unrest and great disasters.

Indeed, I agree that current inflation is unhealthy. Getting back to basics, what we are experiencing is not demand driven. In my opinion, this is mainly caused by an extremely accommodating monetary policy resulting in excess liquidity in the economy, a shortage of supply (due to the prolonged shutdown of Covid-19, the slow restart of the plant, supply chain issues) and an uneven recovery in economies globally.

On August 4, 2021, Janet Yellen, former Fed Chairman and current Treasury Secretary, reiterated the view of President Joe Biden’s administration that soaring inflation reflects bottlenecks in the economy and the challenges of reopening. She believes it’s temporary and will return to normal levels in the not-so-distant future.

On September 29, 2021, current Fed Chairman Jerome Powell maintained his view that inflationary pressure will ease once the supply chain bottleneck eases and demand will return to pre-pandemic levels. Therefore, the argument between policymakers is about tightening supply versus pushing demand and whether it is a transition or a continuation.

To be honest, getting it right is never easy. Given the opportunity, policymakers should be firm in easing off the gas and allowing the economy to run on its own. Accommodating monetary policies and overly aggressive fiscal spending using the pandemic as the sole justification is not good policy.

It is simply taking the easy way out of accumulating more deficits to stimulate artificial growth. I believe that healthy consumer spending is the key to sustainable growth in the economy. As the pandemic progresses for the better, a good place to start is to let the economy return to normal on its own. Tackling interventionist economic extremists is crucial to avoiding complex economic challenges such as potential debts and defaults in the future.

Hann, is the author of Once Upon A Time In Bursa. He is a lawyer and former chief strategist of a Fortune 500 company.

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